Getting a Better Handle on Currency Risk

Recent swings in global currencies have brought exchange-rate risk back to the forefront for companies working with suppliers, production, or customers in different currencies. Although official, or “nominal,” exchange rates tend to draw the most attention, what really matters to companies are changes in real terms—that is, when currency changes are adjusted for differences in inflation. In an ideal world, if prices were to fall as currency values rose, or vice versa, then the purchasing power of companies’ cash flows would be stable, and there would be no real currency risk. That often works itself out over the long term, but not for all currencies and not necessarily in the short term.

Many companies seem to manage only the most visible risks, such as exposure from a large transaction in a developing nation, which can be hedged with financial instruments, including currency futures, swaps, or options. But these tactics don’t work for every currency risk—and companies often face far greater exposure from less obvious risks that are much more difficult to manage, including risk that stems from mismatches between costs and investments in one currency and revenues in another.

What follows is a refresher course of sorts on currency-risk management for companies seeking to get a better handle on the potential impact of currency-rate changes. The most important lesson is that managers can’t always hedge against every currency risk—and often shouldn’t try. But once managers understand how different risks work and interact, they can better measure and manage them with the help of a few general tips we’ve collected from experience.

Companies are susceptible to a range of currency risks, but not all of them are risks they can or should try to manage. Managers would do well to take a holistic approach that focuses on the effect on cash flows rather than earnings and to be aware of the limitations of financial instruments. They should also be more transparent with investors about what risks they face and their efforts, if any, to hedge them.